This is by far one of the most common decisions you will have to make when setting up a plan for saving your hard earned money. You (typically) have a choice of making current year pretax (i.e. tax deductible) savings versus making after tax savings.
Pretax contributions are great because you get the tax deduction right now. You pay less in taxes right now. More money in your pocket on a net basis. One day though, you’ll retire and when you pull that money out of your pre-tax retirement accounts, you’ll owe income tax. The most common example is pretax contributions to your 401(k).
After tax contributions are the opposite of pretax savings. You pay the tax right now with the idea of owing less in the future. For example, in a Roth IRA or HSA, you’ll owe zero income taxes on the growth if planned properly. In a brokerage account you’ll pay long term capital gains tax instead (as opposed to the higher short term capital gains tax).
You will see ‘after tax savings’ and ‘pretax savings’ used throughout the article. That could refer to a number of account types depending on your goals and is beside the point of the article. Regardless, I listed a few account types for clarity.
Now comes the tricky part: How do you decide how much of your annual savings goes to your pretax portion versus your after tax savings? Well, you can start by building a rule for your savings that is tied to your taxable income. The rule is simple: make your pretax contributions based on where your taxable income falls in the federal brackets. Check out below the married filing jointly brackets with the rule implemented:
Or for a more consolidated form:
Let’s run through a couple examples to illustrate what the above really means.
Let’s say you’re a married filing jointly tax filer with gross income of $120,000. You and your spouse have determined that you would like to save 20% of your gross income which is $24,000 a year. Before taking into consideration any pretax savings contributions, you have taxable income of $90,000. Looking at the above chart, that puts you in the “50% after tax / 50% pretax” bracket. This means you will save 50% of their contributions towards after tax savings and another 50% towards pretax. You will continue to save in this fashion until you have enough pretax savings to lower your taxable income into the “100% after tax” bracket. At that point, you’ll save all remaining dollars with after tax money. When your taxable income hits the 12% bracket, you’ll then focus your savings on the after tax component.
Here are the numbers broken down:
Looking at your chart, $90,000 of taxable income has you in the “50% after tax / 50% pretax” bracket. This means every dollar you save will be 50% pretax and 50% after tax. The pretax portion will lower your taxable income until one thing happens:
- You hit your savings goal.
- You hit your pretax savings ceiling whether that be through your 401(k) savings cap, HSA savings cap, etc.
- You reach the next ‘savings bracket’ from the chart above.
Continuing with the above example, you will save 50% pretax and 50% after tax until your pretax savings reach the next ‘savings bracket’ at $81,050 taxable income. The savings needed to reach that point are as follows:
Pretax savings: $8,950
After tax savings: $8,950
This gets you to a total savings of $17,900. With a savings goal of $24,000, that leaves you $6,100 still to save. Based on the next ‘savings bracket’, you will save the remaining amount in your 100% after tax accounts.
We saved a grand total of $24,000 (our goal) broken into:
Pre-tax savings = $8,950
After tax savings $8,950 + $6,100 = $15,050
Limited Pretax Savings
The IRS limits how much money you can save on a pretax basis whether that be with 401(k) limits, HSA limits, etc. In fact, you might not have much access AT ALL to any pretax retirement savings if you are in a high income bracket as a W-2 employee with no access to a 401(k). This might force you to save more towards after tax if you want to hit your goals.
Goals Determine your account type
You need to determine what’s important to you before determining where you are going to save your pretax and after tax money. For example, if saving for a down payment on your first home is important to you, you might favor brokerage or savings accounts over a Roth IRA. If future health expenses are of concern, you might favor the HSA over 401k contributions.
Other pretax 'savings'
Pretax contributions are limited as noted above, but that doesn’t mean there aren’t opportunities to lower your taxable income through other means. For example, charitable contributions could lower your taxable income to get out of the 32%+ tax brackets. While this doesn’t help your savings, it does help with your tax bill.
diversify your money
Diversifying your money as it relates to taxes is equally (if not more important for some!) as important as diversifying your investments. This framework allows you to assign rules to diversify how your money relates to taxes. The million (billion? Trillion?) dollar question is: what will tax rates be in the future? Instead of trying to solve this question, you can use the above framework to make sure your money is set up properly.
Are you looking for a second opinion regarding your saving strategy? Reach out to us today for a chat!